Student debt: simple vs compound Interest
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How does interest work? Do you know the difference between simple and compound interest?
As you start your next phase in life, one of the most important topics to learn about is interest rates. Knowing what they are and how they work will make you a better saver, investor, and you will also be able to make better long term decisions.
One of the biggest mistakes people make is not understanding the cost of their debt, and that means they do not truly know how to best pay off their debt. Similarly, small differences in interest rates can impact your investment gains over your life. Before you get started with your financial journey, let us learn about interest rates.
What is an interest rate?
Economists will tell you that the interest rate is the cost of money. But what does that mean? Well, If you are a borrower looking for money, the interest rate is the amount the lender will charge you in return for giving you access to that money upfront. If you are a lender of money, interest rates are how much you will get paid to give up the use of that money so someone else can use it. Banks and financial institutions serve as the middle point that connects lenders with borrowers and they earn a fee for the service they provide.
Why are there so many interest rates out there?
If you look around there are so many different interest rates. Rates on car loans are different from rates on mortgages. Rates on student loans are different from rates on credit cards. Even more complex is that the rates on the same type of debt might vary from one place to the other. This complexity in rates and terms is one of the reasons that it is hard to shop for debt and probably why many people find it difficult to understand and feel cheated in the process. This video is designed to give you a better idea of how it works, and what to consider when saving money or when borrowing it.
Two main types of interest: Simple vs Compound interest
Simple interest is when the amount paid as a fee is fixed based on the principal amount borrowed or lent out. For example let us say that as a student you borrowed $10,000 and simple interest is 6%, and you have borrowed this money for three years.
Then your interest payment is
10,000 X0.06 X3= $1,800. Therefore in three years you will pay back the 10,000 plus an additional 1,800 for a total of $11,800
Let us compare that to Compound interest, which is what most loans use.
With compound interest, you are charged interest on the principal, and on the additional interest costs you incur during the time you have the loan out.
Let us take the same example above. Using compound interest you would incur the following costs.
You borrow 10,000 today.
A year from today you would have 10,000 outstanding, and you would have incurred 10,000*0.06 in interest. So your outstanding debt now is $10,600. In the second year you would pay interest on the original $10,000 and 600 from year 1, so your total liability now is $11,236.
In the final year you would pay 6% interest on 11,236. This means your final loan payment will be $11,910.16
With simple interest your total payment back at the end of the loan is $11,800, while with compound interest you pay $11,910.16. The difference between the two payments shows you why compound interest can escalate your debt quickly, if you are not careful. On the other hand, compound interest for lenders/savers means that the value of their money grows quicker.
The most common mistake
One of the most common mistakes borrowers make is thinking of interest as simple interest when it is actually compound interest. This is usually the case with student loans. Often I read, on twitter, people complaining about how they have been paying off their student debt but they still owe money or sometimes they would even say they owe more money then they initially started with. This is possible and something you want to avoid.
People in this situation are not paying off enough of their principle with each payment. Their payments are not covering the interest part of the payment. That means although they are paying their loan payments, they aren't paying enough and the loan is actually growing. So I would encourage them to consider their payment schedule.
Also, loan deferral or Income Driven Repayment plans might add to the overall interest you pay. While these options are usually designed to help out in the short run, they can increase the interest accrued and therefore impact how long it takes to pay off your loan.
Keep an eye on your balance! Make sure your payments are making a dent into your principal amount owed.
https://credit.org/blog/what-does-interest-rate-really-mean/
https://twitter.com/veronewyork/status/1378070383908155393?s=20